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Copyright: Toni Straka, 2005-2011 This blog is for information and entertainment purposes only. Under no circumstances does this information represent a recommendation to buy or sell securities or any other type of investment instruments.

Saturday, May 01, 2010

Bronte Capital Chief Investment Officer John Hempton recently came up with the most concise explanation how a Japanese-style bank recapitalization based on near-ZIRP (zero interest policy) can work. But raise the interest environment to higher levels and it's game over.

From John Hempton's email:

Suppose you have an insolvent bank. Assets 100, liabilities 90 - but 30 of the assets are not worth ANYTHING. Further suppose rates are zero to fund the bank, 3 percent to lend, 1 percent of costs - spread after costs of 2%. Costs are on total assets (100) at all times.''

The insolvent bank will have interest revenue of 2.1 (3 percent of 70). It will have funding costs of zero (0% of 90). It will have operating costs of 1 (by assumption).

Therefore it will make 1.1 in CASH PROFITS EACH YEAR.

Run this bank for 20 years and it recapitalises. This happened in Japan.

By contrast presume rates are 10% to fund and 13 percent to lend - the same 3% spread.

Assume operating costs are the same.

The bank will have interest revenue of 9.1 (13 percent of 70). It will have funding costs of 9 (10% of 90). It will have operating costs of zero.

It will have - pre-credit losses - an OPERATING LOSS of 0.9 per year. The bank NEVER recapitalises.

Remembering that Eurozone inflation has surpassed the European Central Bank's main refinancing rate of 1% by 40 to 50 basis points in the last 3 months - latest Eurostat figures (pdf) put Eurozone inflation in April at 1.5% this paints a black picture for a recovery a la Japan which was able to deflate for 2 decades.

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About Me

I am an INDEPENDENT Certified Financial Analyst who worked as a financial journalist for 15+ years and now evaluate global market trends. Analyzing financial and political news permanently I want to share my insight with those who understand that we are in an era of global redistribution of wealth. The US-European centric approach does not work anymore. 6 billion people in the developing countries now demand their fair share of the world's resources.
Having worked many years for a leading newswire I have learned to understand the fatal concept of ever expanding credit by heart. If you want to learn about the future of the economy, study history.